Hedging Downside Risk in a High Volatility Environment

Yesterday, we bid farewell to the first quarter of 2015 and with any luck the boardwalk roller coaster ride that presented  near vertical plunges (January), break-neck inclines (February), body jostling twists and turns (March) only to wind up back precisely where we started!  The S&P 500’s well-defined broad and volatile trading range appears symptomatic of the broadening polarization of market convictions.  Like Washington politics, the once vast middle-view investor has all but vanished as participants have become either increasingly bullish or bearish.  If there lives a shred of commonality on our next market move, it would likely revolve around the upcoming earnings season and clarity on precisely when the Fed will first raise rates.

Most would quickly agree that shopping and paying for insurance is a dreadful experience as it’s either too expensive and/or winds up not covering as thought.  There’s a profoundly innate, negative inner-reaction to forfeit funds for something you hope you don’t need yet, you know, deep down, that you must purchase this policy while you can and not when you have to!  Options as a hedging mechanism is analogous – it can be expensive, there exists a high deductible, and it absolutely may not cover you as hoped or planned.  However, you can be correctly covered if you are willing to pay for the right policy and do so with the thinking that you hope you never use it!

Justification in (relative) purchasing options in a high volatility environment

Currently S&P 500 Implied volatility levels are relatively high – depending on the expiration month option premiums are averaging near the 75th percentile.  Purchasing options with a relatively high implied volatility is stacking the odds against you, so the story goes. You have so many things working against you, the biggest being time decay. Yet some of the best buying (volatility) opportunities exist during periods of high implied volatility. In contrast, and with an appropriate amount of hindsight, some of the best-selling opportunities have existed during low levels of implied volatility. The markets are random; but remember, implied volatility is high or low for a definite reason.

Making (relative) sense of options implied volatility skew levels

Similarly and coincidentally, S&P 500 implied volatility skew (i.e. implied volatility or premium difference between equidistant calls and puts) is trading near the 75th percentile.  Other words, out-of-the-money puts are trading with more premium than their equidistant out-of-the-money calls and, have only traded higher than this 25% of the time. When skew is higher than average or lower than average, you may well learn something from that. But analyzing skew involves a variety of components that more often than not can only be described with the benefit of hindsight. Changes in skew can be produced by ordinary supply and demand, the opinions of options market makers, or from a hedge resulting from a large off-floor trade. There have been periods where skew was so cheap that a trader’s chief concern became how many puts the market makers could actually afford to finance. With that quantity of long (skew) supply being held by market makers, the skew became as flat as anyone had seen in modern memory. In that scenario, would a flat skew necessarily imply anything? Maybe.

How to think rightly on hedging your downside risk in current volatility environment

As noted we are in a relatively high implied volatility and skew environment - one where purchasing a put vertical spread would cause you to buy “relatively high implied volatility” yet, potentially offsetting that by selling “relatively high implied volatility skew”.  In this scenario, it’s vital to recognize that in order to potentially take advantage of this “high volatility, high skew” environment, you must purchase a very near at-the-money strike (put) and sell a further out-of-the-money strike (put).  Other words, purchasing a 50 delta put and simultaneously selling a 30 delta put is both buying implied volatility and selling implied volatility skew – apt for this present volatility environment.  However, not all put vertical spreads are created equal! Example:  purchasing a 30 delta put and simultaneously selling a 5 delta put would, in effect, be buying both implied volatility and skew.  It may wind up being a great trade however; it’s not taking full advantage of optionality.

Optionality or simply give me the right downside insurance with a put vertical spread

This is where it gets very simple whereas the higher the deductible – i.e. the more your willing to pay upfront – has a direct correlation to the level or immediacy of protection.  Consider the SPDR S&P 500 ETF (SPY) referenced: $206.43 - you wish to purchase insurance via. a put vertical spread with September, 2015 options.  Furthermore, you are considering the following strike prices and option prices: 205 ($8.85), 195 ($5.87), 185 ($3.80), 175 ($2.25), and 165 ($1.40).

Purchasing the 205 put for $8.85 while simultaneously selling the 165 put for $1.40 (or, a net debit of $7.45) is the most expensive put spread yet, as an off-set, it will provide you with the quickest protection as your break-even point would be 197.55 or, down .043% from the current SPY price. Furthermore, you are risking $7.40 to possibly make as much as $40.00 (or, a net of $32.60) if SPY trades at or below 165 by September expiration.

Compare that with the cheapest insurance, purchasing the 175 put for $2.25 while simultaneously selling the 165 put for $1.40 (or, a net debit of $0.85).  This spread will eventually provide downside protection however SPY shares would need to drop to 174.15 or down 15.6% from current levels for real protection to kick-in.  Additionally, you are paying $0.85 to possibly make as much as $10.00 (or, a net of $9.15) if SPY trades at or below 165 by September expiration.

Successful traders ask themselves how to hedge rather than when to hedge.  Hedge your risk while you can – not when you must!